Inflation: The Fed’s Coffin Corner
With over a year in the political spotlight, it seemed time to address the big domestic political issue in the US: inflation. There’s a lot of bad economics out there about what inflation is and how it’s caused, so let’s start with a very simple example that illustrates inflation:
Imagine there are 10 people who all have $10, and all that any of them want for their money is as many oranges as they can get. If there are 100 oranges for sale and the seller doesn’t want to keep any for themselves, then the only price it makes sense for them to sell the oranges for is $1 each. At this price, they could sell the whole lot and earn all $100 held by the 10 buyers. Any less than $1 each, and they would be leaving profits on the table. Any more than $1 each doesn’t gain them any more money, since there’s only $100 to spend among the 10 buyers, so they’ll simply be left with excess oranges, which we said they didn’t want for themselves, and by raising the price while having excess, they lose goodwill with their customers, who would be more motivated to take their business elsewhere. So the price stays at $1.
Now, imagine we double the money supply by giving each of the 10 buyers an additional $10 of newly-printed money, while the number of oranges stays at 100. In this case, if the seller keeps the price at $1/orange, they’ll only make $100 out of the $200 available, and each buyer would be left with $10 if each bought 10 oranges, as in the original situation. Since all they want for their money is oranges, they’d be willing to to use their remaining $10 to buy oranges. The seller, noticing this, can simply double the price of the oranges so that all 10 buyers would again spend their whole budget and receive 10 oranges. Thus, inflation has cut the value of $1 from being worth one orange to half an orange.
Now, imagine the same situation with 10 buyers having $20, but the additional $10 each received came from a government works program in which each was paid $10 for planting/maintaining orange plants. As a result, the number of oranges available rises to 200. Now, there are as many oranges as dollars, like the first example, and raising the prices of oranges wouldn’t gain the seller anything, so the price of oranges stays at $1. This is one of the points that’s often missed: if an increase in the money supply is accompanied by an equivalent increase in the supply of goods to be bought, it doesn’t cause inflation.
Finally, let’s assume nothing is done to the money supply from the initial example, so everyone still has just $10, but there’s a drought that causes half the orange plants to die or not produce that year, so there’s only 50 oranges total. Once again, there’s more dollars than oranges to buy for them, so the seller can once again increase the price. In this case, the dollar has once again been inflated without any money printing at all, simply by a reduction in the supply of goods.
From these example scenarios, we can learn the basics of how inflation happens. Obviously real economies are much more complex, so the inflation effect isn’t nearly as clean mathematically as this example, e.g. prices doubling if the money supply doubles. The example is meant to show the general concepts and not exact numbers. Namely, inflation is a result of supply and demand for goods, with increases in the money supply increasing the demand for goods. The points that follow are:
When the demand for goods goes up (money supply increase), but the supply stays the same, prices increase (inflation).
When the demand for goods remains the same, but the supply drops, prices once again will rise.
If the demand for goods goes up and the supply of goods also goes up by enough, it won’t cause inflation. There’s of course in-between scenarios where supply goes up a bit and reduces but doesn’t eliminate the inflation vs. case (1).
So, despite what the economic reductionists say, printing money doesn’t necessarily cause inflation (#3), and also isn’t even needed to cause inflation (#2), even though it does play an essential role in determining the level of inflation. Another claim I’ve heard countless times over the past year is something to the effect of:
This isn’t inflation, it’s corporate greed
With many companies recording record profits while inflation soars, it’s not surprising some would think this, but it’s wrong for multiple reasons. First: there’s no difference. If prices rise, it’s inflation, regardless of who or what is driving it, including corporations raising prices to maximize profits. Second, which I believe is more important, is that this framing is giving way too much credit to the free market/corporate system. If the inflation of the past year is just the result of corporate greed, what does that mean about those corporations before the last year? They weren’t just as greedy? That’s ridiculous. Corporate profiteering has and will always exist unless regulations force them to do otherwise, it’s not like that’s something new this past year. Just over a hundred years ago, there was a court ruling in the US that determined it was illegal for corporations not to be greedy. To act like this is a new problem is simply ignoring the entire history of corporations. In fact, the free market system is one in which money rules all, meaning the corporations that are greedy – through price gouging; cheaper, less environmentally sustainable practices; and bribing politicians for government handouts – outperform their competitors. We’ve created a survival-of-the-fittest system that mimics the evolution seen in nature in a way, but which drives corporations to be more greedy. By blaming “corporate greed”, it makes it seem like a few bad actors within corporate America have caused problems with it, but that’s far too generous. If the system is designed to incentivize greed, you’re going to get greed, no matter how many bad actors you pick out of the system. If you want to get rid of corporate greed, you need to change the entire corporate system. Unfortunately, 100% of Republicans and about 2/3 of Democrats in office are entirely opposed to doing so, meaning corporate greed will inevitably continue unless Americans stop voting for free market advocates, shifting left instead, and, probably most importantly, unionizing.
So now that we’ve addressed some myths about inflation, let’s talk about how we ended up here, and what can be done.
COVID, and the governmental & economic response, created a perfect storm for inflation: in order to avoid deflation (which is worse than inflation, explained below, and was the cause of the Great Depression) as a result of the economic shutdowns, the Fed had to print a massive amount of money to prop up markets by buying financial instruments like stocks and bonds to keep their prices high. Stimulus payments were also sent out, but were relatively small compared to the Fed propping up markets. Doing these increased the money supply & thus demand for goods once things started to open up more. At the same time, the lockdowns caused a decrease in supply of many goods for a number of reasons. Difficulty hiring the labor necessary is one that’s talked about often, but there’s more important ones that are often ignored by the corporate media.
Chemical plants, oil refineries, and the extractive sites like mines & oil wells that supply them became unprofitable to run when the demand for their output dropped due to lockdowns, so they were shut down. People not familiar with these industries may not realize that shutting down/starting up these massive systems has a substantial cost; it’s not just an on/off switch like a light bulb that can be flipped once demand returns. In the case of oil wells, it often becomes completely against corporate profit interests (which, again, drives all decisions in our free market system) to start the well up again at all, because of the cost associated. So those wells don’t get started up again when the demand returns.
Republicans want you to think the high oil prices are due to Biden not giving out enough oil contracts, but in reality barely half the land currently under drilling permit is actually being drilled. When half the possible oil production simply isn’t being tapped because the companies operating in the free market decided so, there’s no reason to think giving them more contracts would change anything. The government approving drilling sites is simply not the bottleneck. Blaming the cancellation of the Keystone XL pipeline is even more obviously wrong: beyond the fact that it wouldn’t be finished yet anyway, pipelines simply don’t produce oil, they only move it. This argument is like saying the way to reduce car prices is to build more roads.
Additionally, supply chains have been driven, once again by the free market system and its profit motive, to reduce inventory over the years, since inventory costs money to hold. If a company can buy just as much as it needs at a given time, they don’t need to pay for inventory, and thus save money, maximizing profits. This is called just-in-time sourcing, which is a part of the “lean manufacturing” method Toyota started and most manufacturing companies have adopted since. It works great for maximizing corporate profits when supply chains are stable, but when there’s a disruption, like the worst pandemic in 100 years, it makes the consequences much worse. If a car company like Toyota depends on a computer chip company, who depends on a chemical company, then when disruption happens, their lack of inventory becomes a problem. The chemical plant shuts down to reduce losses when demand drops, and takes some time to restart when demand returns, as explained above. The computer chip company then takes even longer to ramp production back up, since it’s waiting for the chemical plant to restart before it can start to ramp up, because it didn’t keep inventory to hold them over during disruptions. The same happens with the car company, who needs to wait for both of the other two to ramp up production before they can. And this is a vastly simplified supply chain. Imagine a supply chain sourcing from 50 different companies, where any one of them can hold back the final product. Slight disruptions get amplified in this system, since all the resiliency that inventory provides was cut in the name of short-term profits. The free market strikes again.
So COVID gave us a lower supply of goods from its economic impact, and a higher demand, due to the response to that economic impact, which is the perfect combination to cause inflation. But even with these forces driving inflation, there’s still much more to the story.
In the US, the entity tasked with controlling inflation is the Federal Reserve, or Fed. The Fed is a private bank (though its board members are political appointments by the POTUS/Senate) that’s allowed to print as much new money as it wants, giving it sole control of the money supply. It has three levers it can use:
Buy/sell financial instruments like treasury bonds. If the Fed prints money to buy bonds from the Treasury or a bank, it introduces that new money into the system (quantitative easing, the main source of increased money supply in the past ~2 years). If it sells bonds back, the Treasury/bank is giving money to the Fed, which is thus taken out of circulation, reducing the money supply
Change interest rates. If interest rates are high, you can get good returns by simply keeping money in a savings account. But if they’re low, that’s not true, and banks and investors will want to reinvest their money, since that’s the only way to get good returns. This means that when the interest rate is lower, more money is in circulation rather than locked up in savings, effectively increasing the money supply, even if it doesn’t change the number of dollars in existence.
Change the minimum reserve ratio. This works similarly to #2. When someone puts money in a bank, that bank is only required to keep a certain percentage (the reserve ratio) of that money, and can reinvest the rest of it. This means if the reserve ratio is low, most of the money people put in banks gets reinvested, once again effectively increasing the money supply without changing the number of dollars in existence, by keeping fewer tied up in savings.
In periods of economic stagnation, increasing the money supply can be useful in stimulating the economy. This is why the government and Fed use deficit spending (which often gets paid for by printed money) and a decrease in the interest rate when there’s a recession. But the only way this can be done responsibly is to then pay down the debt and raise the interest rates when times are good economically, giving yourself margin to use on both fronts once the next downturn inevitably comes. This is where the Fed and the federal government have failed.
In 2019, when Trump and his followers where bragging about how great the economy was doing, the more savvy observers noticed two counterpoints. First, the stock market isn’t the economy, and second, the reason the stock market was doing well was that they were deficit spending with a low interest rate like it was an economic downturn. This blog even noted in a 2020 post that Trump’s average deficit before COVID was the highest of any US president ever. If the economy is doing well, running up record-high deficits and keeping the interest rate low is wildly irresponsible.
In aviation, there’s a concept called coffin corner, which, very generally, is when an airplane enters a dangerous situation where it can’t gain or lose any speed without stalling. So, for safety, you need to avoid this. It happens because there’s both an upper limit & lower limit beyond which the airplane will stall, and the two eventually converge with enough elevation, making it impossible not to stall. The situation the Fed is in now can be broadly equated to a coffin corner.
With interest rates already low before COVID hit, the drop in interest that was possible didn’t do much to stimulate the economy, so printing money and increasing deficit spending was the only option to avoid deflation. But there was already high deficit spending, which made this option doubly-dangerous to long term economic health. While dangerous, it was the only option they had, since Trump’s first three years didn’t follow the sustainable economic model of saving up while times were good to be prepared for the bad. This is not to pin the inflation on Trump. Trump didn’t help, nor has Biden, or any president over the past 40 years, with the possible exception of Clinton, who did balance the budget. But, as I’ll explain later, even he bears some responsibility.
As a result of the irresponsible policies of the past decades, the Fed is now trapped. Inflation is high, and it’s supposed to be their responsibility to control inflation, but they don’t have any good options to do so. They are going to sell back some of the stocks and bonds they bought through quantitative easing. Doing so would presumably crash the markets while reducing the money supply, which risks deflation, so they can only do so much. Back in the 70’s & 80’s, the US had a similar stagflation scenario, where there was inflation with stagnant economic growth. This period was ended by the Fed’s monetary policy under Jimmy Carter’s appointment to Chairman, Paul Volcker. He raised interest rates, briefly exceeding 20%, which caused a relatively minor recession, but ended the inflation problems, and when the recession ended, growth resumed. Reagan reappointed him after this success. Since then, the interest rate has followed a general trend downwards, and it hasn’t reached 6% in the past 10 years.
So the narrative now is that the Fed will increase interest rates to mimic the Volcker solution, but there’s a significant difference between the two situations: the national debt. More importantly, debt:GDP ratio, because a country with $100 in debt that only has $3 of economic activity a year is going to have a harder time paying that debt than a country with $1 billion in debt but $10 billion in economic activity. Let’s take a look at the debt:GDP ratio over time, along with the Fed’s interest rate:
As you can see, the debt:GDP ratio is much higher now than it was around 1980, when Volcker raised interest rates. In fact, 2020 was the highest the debt:GDP ratio has ever been in the US, and 1981 was the lowest it’s been since WWII, so the two scenarios could not be more different from this standpoint. And here’s the reason this is significant: every year, part of the federal budget is interest paid on the debt the US holds, and increases to the Fed’s interest rate means more interest has to be paid on the existing debt. Our debt:GDP ratio is now 4 times higher than it was during the last stagflation period, meaning raising interest rates to the level Volcker did would be substantially harder to pay for. This is why you can see a clear downward trend, among smaller ups and downs, in the interest rate over the past 40 years, as the debt has grown: the lower interest rates are the only way we can afford to hold that much debt.
A drastic increase in the interest rate would mean more tax dollars than ever would go towards simply paying for the interest on the existing debt. And since the US hasn’t balanced a budget since Clinton’s last year in office, this additional debt interest would be added to the expense pile that’s already substantially higher than the tax revenue pile, making the debt increase at an even faster rate. This creates a feedback loop that exacerbates the problem by adding more debt each year as a way to pay off the interest on past debts (and not even the past debt itself, simply the interest on it), increasingly pushing the possibly of balancing a budget out of reach, requiring more money printing and more inflation. So we either eat the inflation now, or we cause a recession to temporarily stop inflation while making the underlying cause worse, leading to even worse inflation in the future. Or we default on our debt and destroy the entire global economy and the USA’s seat of power within it (not gonna happen).
Now we’re beginning to get to the root of the problem: while COVID may have been the catalyst that made the inflation happen when it did, inflation was going to happen sooner or later due to the past decades of reckless deficit spending that mainly just gave money to rich people instead of something that would increase GDP, like a federal jobs program for building infrastructure. When you deficit spend in order to give wealthy people money, that increases the debt, which in turn increases the expenses due to interest on debt. This creates a larger deficit the following year, increasing the debt even more. This happens year after year, compounding until there simply is no way the debt can be paid down through taxes, because the interest on it alone is too much to afford. As seen in the graph above, this is what has happened since 1981, when the debt:GDP ratio was at its lowest post-WWII. During the 90’s things trended in the right direction, and there still may have been a chance to correct course, but the US chose not to. Instead, we doubled down on deficit spending to give wealthy people more money, and landed ourselves in the current predicament.
When you get to the point that the interest on debt is too much to overcome with taxes, the only options the country has are to default on the debt, which we already said wouldn’t happen, or print money to pay off the debt, causing inflation. The inflation reduces debt:GDP because as prices rise, that means the GDP rises, but the debt stays the same, or goes down thanks to printed money paying some of it off. Ultimately, the inflation rate and interest rate compete in how they impact the debt. Higher inflation reduces the value of the debt, effectively making it cheaper and easier to hold, while higher interest rates make it more expensive to hold, as interest payments on it rise. Opposite of inflation, deflation makes the value of the debt larger, which makes it harder to pay debts of all kinds, government, corporate, and personal. Since interest rates have been low and inflation has been high, borrowing money has been cheap, so our old friend the free market led most companies to take on more debt in order to expand. So if we switch from that to deflation, there will be a cascade of defaults on that debt, bankrupting companies, which is why deflation is seen as more dangerous than inflation. The Fed thus intentionally maintains a certain level of inflation to avoid this deflation scenario. They even publicly stated in 2020 that they were planning to increase inflation above the standard 2% target.
So if inflation and interest rates work in opposite directions regarding affording the debt, that means that, given the debt:GDP is at a record high and we can’t pay it down with our current tax revenue, the Fed needs to keep the inflation rate above the interest rate to effectively reduce the debt. The recent rate increases that have caused the stock market to pull back were less than 1%, nowhere near the levels needed to end the last period of high inflation. We’ll probably see more increases, but I don’t expect inflation to drop to the usual target of about 2% any time soon. The best way to deal with a coffin corner is to avoid it in the first place, but we already failed at that. This situation has been inevitable for decades, assuming we follow free market ideology, and at this point, inflation is unfortunately the best option left to get out of it.
So who’s to blame?
More than any one person or group of people, our free market system bares most of the blame. With a government interested in economic sustainability, we could have kept oil wells active during lockdowns, building up a reserve supply, but instead the free market decided to shut them down when demand dropped, causing oil prices to rise once demand returned, rather than stay low due to the excess we would’ve had without shutting them off. Supply chains with inventory maintained would’ve been more resilient to shocks, but the free market cut that resiliency in favor of short-term profits. The free market allows people/corporations with wealth to influence politics, and since doing so is profitable (via deregulation so they can cut corners and tax cuts to the wealthy and corporations), it makes it inevitable within a free market system that politicians will be bought by big money and implement these reckless policies.
So is Biden to blame? Sure, as is anyone else who bought into this free market system of the past 40ish years. But that list includes: every president, the vast majority of legislators (all but the Bernie Sanders types), and the majority of voting Americans in that time. This is why Republicans are blaming Democrats and Democrats are blaming Russia: Aside from the left flank of the Democratic Party, both parties are paid by big money interests to maintain the free market, which is the real cause of the inflation. Clinton did balance the budget, but was still a free market advocate, and was more just in the right place at the right time during the dot-com boom. If we are to blame one person though, we should start by looking back to the graph above of debt:GDP. In 1981, the graph reverses its steady decline, and begins a steady increase, besides Clinton’s term. So what exactly happened in 1981 that could’ve started this?
Why of course, the United States’ patron saint of free market economics, Ronald Reagan, took office and quickly got to work jacking up the deficit to record highs. If any one person is to blame for the inflation today, it’s him. A literal actor turned literal corporate propagandist whose economic policies were so reckless his own vice president called them voodoo economics (before more-or-less following them himself). His tax cuts to the wealthy began the cycle of unmanageable debt that led us to where we are today. If only people could’ve realized not to trust the actor who said the best thing for the economy was to give money (funded by the middle class through future tax hikes and inflation) to the billionaires who hired him to lie to the public on their behalf… If only…
But unless someone invents a time machine, it’s not useful to blame a man who was president 40 years ago. There’s plenty of blame to go around to this day, to everyone who helps to maintain the trickle-down, free market system that Reagan started decades ago. One of the most common counter-arguments people give to Keynesian ideas like the New Deal that seek to grow economic prosperity by pulling those at the bottom up is that “we can’t afford it”. But a simple look at the debt:GDP ratio shows that the Keynesian economics followed from the 30’s through the 60’s and somewhat in the 70’s (it was trending more towards free markets in this decade) has factually done better than the Reaganomics of the 80’s onward when it comes to us “affording it”.
This is why free market advocates need to talk in hypotheticals like “the recovery from the Great Depression would’ve gone better with free market economics” or “things today would be worse with Keynesian economics”: because all the actual facts from history say the opposite. The Great Depression was caused by free market economics, then the middle class boom followed when the US went to Keynesian economics, and the middle class has declined since we went back to the free market. Thus, the free market advocates tell you not to learn history “because it’s socialist brainwashing”, make up their own stories (AKA lies), and hire actors to tell them to people. Some will even tell you Thomas Jefferson, who said “I hope we shall crush in its birth the aristocracy of our monied corporations” agreed with their pro-corporate free market ideas.
WWII, a noble expense, dramatically increased the debt, but after that, the US consistently reduced the debt:GDP ratio while having the New Deal policies that increased middle class prosperity, and also fighting other wars. But since Reagan took office, we’ve done the opposite while harming the middle class’s prosperity. This is because, among other things, Keynesians understand the need to tax the wealthy and corporations, so contrary to what the free market advocates will tell you, Keynesians are more responsible economically. But too many working/middle class people are too distracted by culture war issues & ignorant of the history to realize that and change. It’s already too late now to avoid this cycle of inflation to reduce the debt:GDP ratio accumulated through Reaganomics, but the question today is what to do to affect our future prosperity. We can return to what’s worked by voting for progressives in favor of things like universal healthcare, the green new deal, and higher taxes to the wealthy and corporations, or we can allow the free market that’s robbed the middle class of its prosperity for the past 40 years to continue, leading to even worse hardship.
